accounting essay

Exploring different methods used to measure accounting quality

Published: 23, March 2015

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Recent research literature discusses several ways to measure accounting quality that has some economic effects. For instance cost of capital, frequency of capital sharing (Sun 2006) and global resources (Young and Guenther, 2002) cited in Soderstrom and Sun (2007) has some profitable outcomes.

The presence of accounting quality is always capable to change. Frankel and Li (2004) also argue that accounting quality also minimises incorrect information with the help of using accurate and appropriate information. For instance: in Barth et al (2006) article mentioned that higher accounting quality remains in IAS resulting in low earnings management and more timely loss recognition in addition to majority reliability value of earnings. Value relevance is associated between movements in stock prices as well as earnings and net book value of equity (from lecture notes).

Schipper and Vincent

Moreover accounting quality measures FASB conceptual framework their main aim for financial reporting is to give data which is helpful for business decisions and it is also well-mannered as well as used in accounting research for measuring accounting alternative or study.

Now, we can move on second measurement of accounting quality like Hicksian income. Earning quality at that point where the faithful representatives is called Hicksian income (Schipper and Vincent, 2003:98), however "faithful representatives means correspondence relationship among measure and phenomenon that it represents" generally it is highlighted.

Whereas accounting to Bellovary et al (2005) argues that earning quality is ability of detailed income to show the firms fair earning along with the worth of detailed income to forecast future earnings. Earnings quality includes stability, reliability, persistence and shortage of variability in detailed income.

There are several methods of accounting quality relied on recent researchers such as Schipper and Vincent and Hee they are as follows:

Persistence

Predictability

Variability

Let us understand above mentioned methods in detail as follows:

Persistence: According to Hee (2008) persistence earnings define current period of earnings shock as unexpected change in earnings affects future earnings (Pg. 1). Main advantage of persistence earnings method is that it focuses on maintain ability of earnings which is crucial for shareholders in terms of evaluation purposes, in company with it also reflects maximum with larger shareholders response to detailed income and generally represented of earning quality (Schipper and Vincent, 2003). In Schipper and Vincent is also mentioned that in persistence there is major quality measured by unpredictable earnings so in short there it pursue random walk whereas low quality is known as low serial correlation. On the other hand one disadvantage of persistence method; is not related to the faithful representative earnings to hicksian income because of two reasons. Firstly, persistence of the detailed income is a function for accounting methods and reporting body business model and effective surroundings so it is far away from faithful representative. Secondly, in case of economic values of asset and liability pursue random walk, and then hicksian income will be same to the valuation in net financial assets, which will follow noise process that reveal no persistence.

Maintainability income reoccurring dependable earnings from the firms core activities. In addition, measured as the amount of the stock market effect to earnings changes - the slope coefficient of earnings revert on stock return. Highly sustainable earnings are assumed to be more stable and less temporary (Lecture notes).

Predictability: The word itself talk about ancient times earnings that to forecast upcoming earnings by Lipe (1990) cited in Schipper and Vincent (2003) predictability is not attached to the representative faithfulness any more. The major reason is business models. Faithful representative involves high quality earnings which are similar by Hicksian income; the outcome will be shortage of predictive ability as low quality earnings which are same as predictive ability criterion. Financial reporting is also having a capacity to predict earnings or cash flows.

Disadvantage of predictability is it is used only for decision usefulness and not for representative faithfulness with differing level of persistence. Secondly it is useful for time period only. There is innovation takes place after every period of time but recent researchers also notices that prediction cannot be taken more than one year period because they do not have any particular choices left.

Predictability is relied on decision usefulness of accounting it develops from an future cash flows value. Also it is not related from Hicksian prospect.

Variability:

Smoothness is sometimes associated with high-quality income but also to income manipulations

Smoothness can be a positive feature if the business model and the economic environment are stabile and not volatile. If not, smoothness can be a sign of earnings management. Income smoothing is faithful to neither income for decision usefulness nor Hicksian income

Whereas Barth et al (2008) has some different measures for accounting quality such as earnings management and timely loss recognition. Earnings management is divided in three parts such as

income smoothing or earnings variability,

the relation between accruals and operating cash flows

Treatment of small positive profits. On the other hand timely loss recognition involves only one part such as treatment of large negative net income.

Let us understand them in detailed as follows:

Earnings management: earning management defines a scheme used by the organization of the firm on purposely influence the firm earnings so that the targeted figure and outcome figures can be matched. This can be happened by income smoothing (investopedia).

First of all we need to understand what is earning management? Generally there is no specific accepted definition of earning management. Even though Bishop (2001) defines earning management is practical and officially permitted management decision making and coverage intended to get constant and knowable financial results. Furthermore, earning management is also recognised as cooking the books (Bishop, 2001). Now let us discuss three parts of earning management respectively

Income smoothing or earnings variability: According to..... earnings management is stable then as a result of that company with maximum income exhibits minimum earning management more timely loss recognition as well as maximum value significance of income and justice book value. If earning management is less then ultimately there is maximum earning variability. Earning smoothing is also less manifest in common law countries along with that IAS are based on conceptual framework which is parallel to common law countries. If income smoothing is more as a result of it there exists negative relation among accruals and cash flows (Leuz et al).

http://warrington.ufl.edu/fsoa/docs/TAR_income_smoothing.pdf

Second advantage of income smoothing is there is a relationship between income and share prices due to that income smoothing is maximises. Third advantage of income smoothing is that minimise risk received by shareholders. In addition, there is always a good relation remains between customers and trader, to suggest about convey prospect expansion prospects to shareholders, smooth earnings also diminish the cost of borrowing and to constructively affect the terms of trade with trader and consumers.

There is certain disadvantage of income smoothing and they are as follows because it does not reflect accurate data of any particular employee family information or financial assets; due to that it does not have any influence on earning smoothing or payroll taxes.

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